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15 Aug 2018

Secular bull market in the U.S. remains intact, but pullbacks are likely

After searching for direction, it appears stocks have found some balance, at least for now. Major U.S. indexes have moved out toward the high end their recent ranges; with the NASDAQ recently hitting a new high and the S&P 500 threatening to do so, before again pulling back on continued trade tensions.

Gains appear to have been fueled by a mix of continuing good economic news, with second quarter real gross domestic product (GDP) growth coming in at an annualized rate of 4.1% according to the Bureau of Economic Analysis. More than $20 billion was pulled from stock-focused mutual funds and exchange-traded funds (ETFs) in June, according to Morningstar—capping the third worst first half for equity flows in the past decade. The trend doesn’t appear to be changing as investors redeemed another $11.6 billion from domestic stock funds in the three weeks ended July 18. That healthy conflict between optimism and skepticism can be a good mix for stocks, as we’ve seen recently; but can also change relatively quickly so staying disciplined and not chasing returns remains important.

One reason for caution is that we’re entering what has traditionally been a tough time for equities. As we’ve noted before, midterm election years have been rough for stocks, with the average decline or “drawdown” being 17% in the S&P 500 since 1950, with much of the weakness clustered in the summer months. However, going from each of those midterm drawdowns’ troughs, the subsequent one-year performance was a strong 32%. History certainly doesn’t guarantee the future, but it does give us some reason for a bit of caution over the next couple of months.

Trade continues to dominate

Also raising our level of caution is the ongoing trade disputes going on between the United States and China, among other countries. Investors are digesting concerns increasingly being mentioned on corporate conference calls during second quarter earnings season so far; but have yet to see significant impact on the economy. Confidence surveys remain elevated, with regional surveys such as the Richmond Fed Survey remaining well in territory depicting expansion; while the national Institute of Supply Management’s (ISM) Manufacturing Index remained elevated at 58.1, although down slightly from the previous month. The weakness in the new orders component was more pronounced. In fact, ISM has been noting that many respondents to their monthly survey mentioned trade concerns.

We were modestly encouraged by the results of the meeting between President Trump and European Commission President Jean-Claude Juncker, which resulted in a standing down of the escalating tensions between the two regions. Of course, no firm agreements were agreed to, other than to hold off on further tariffs for the time being, so things could still escalate. And of course there have been no signs of thawing between China and the United States, with the Trump administration now threatening to up the tariff rate on $200 billion worth of Chinese goods from the proposed 10% to 25%. For now, only the European developments, as well as some apparent progress with NAFTA deals, give us some hope that we may not descend into a full global trade war.

Despite trade-related concerns, companies largely bested even elevated consensus earnings expectations, with Thomson Reuters reporting that 80% of the 380 companies in the S&P 500 having reported so far have beaten earnings estimates, well above the average beat rate of 68.3%. Even with these better results, estimates for the remainder of 2018 and calendar year 2019 continue to move higher.

Corporate confidence and strength can also be seen in the labor market as jobless claims—the most leading of jobs indicators—recently hit the lowest level in more than 48 years.

That’s backed up by the more lagging data out of the Bureau of Labor Statistics, which showed although a fewer-than-expected 157,000 jobs were added in July, the previous two months were revised higher by 59,000 jobs and the unemployment rate moving down to 3.9%. The tight labor market still isn’t resulting in a surge in wage gains as the average hourly earnings number rose a modest 2.7% year-over-year.

Fed continues to seek balance

Wage gains and the tight labor market are playing into the Federal Reserve’s plans for upcoming Federal Open Market Committee (FOMC) meetings. Their most recent meeting resulted in no action on rates, as expected; but the market is nearly fully pricing in a hike in September. The messaging from the FOMC lately—including from Fed Chair Jerome Powell—is that the Fed is no longer on “auto pilot.” Future moves will apparently be more reactive to economic developments, which could result in more volatility and uncertainty; especially given that every FOMC meeting starting in January will have a press conference tied to it (thereby making every meeting a “live” one).

So what?

Tension between good news and investor concerns is often a good place for stocks to be, but that environment can change quickly; and with us entering a historically difficult seasonal time of the calendar for stocks, we urge discipline, including around diversification and rebalancing. Corporate earnings and the U.S. economy remain strong, but trade concerns, midterm elections and monetary policy concerns pose risks. We believe the secular bull market in the United States remains intact, but pullbacks are likely.

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The S&P 500 Composite Index is a market capitalization-weighted index of 500 of the most widely-held U.S. companies in the industrial, transportation, utility, and financial sectors.

Richmond Manufacturing Index A gauge of broad activity in the manufacturing sector located in the Fifth Federal Reserve District, published by the Federal Reserve Bank of Richmond. The index is a composite index that represents a weighted average of the shipments, new orders and employment indexes. Each index is a diffusion index, i.e. it is equal to the percentage of responding firms reporting increases minus the percentage reporting decreases, with results based on responses from 80 out of 110 firms surveyed.

The Institute for Supply Management (ISM) Manufacturing Index is an index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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